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1. Capital BudgetingCapital Budgeting
Meaning of capital budgetingMeaning of capital budgeting
SignificanceSignificance
Capital budgeting processCapital budgeting process
Investment criteriaInvestment criteria
Methods of capital budgetingMethods of capital budgeting

2. MeaningMeaning
 The process through which different projectsThe process through which different projects
are evaluated is known as capital budgetingare evaluated is known as capital budgeting
 Capital budgeting is defined “as the firm’sCapital budgeting is defined “as the firm’s
formal process for the acquisition andformal process for the acquisition and
investment of capital. It involves firm’sinvestment of capital. It involves firm’s
decisions to invest its current funds fordecisions to invest its current funds for
addition, disposition, modification andaddition, disposition, modification and
replacement of fixed assets”.replacement of fixed assets”.
 ““Capital budgeting is long term planning forCapital budgeting is long term planning for
making and financing proposed capitalmaking and financing proposed capital
outlays”- Charles T Horngreen.outlays”- Charles T Horngreen.

3.  ““Capital budgeting consists in planningCapital budgeting consists in planning
development of available capital for thedevelopment of available capital for the
purpose of maximising the long termpurpose of maximising the long term
profitability of the concern” – Lynchprofitability of the concern” – Lynch
 The main features of capital budgeting areThe main features of capital budgeting are
a. potentially large anticipated benefitsa. potentially large anticipated benefits
b. a relatively high degree of riskb. a relatively high degree of risk
c. relatively long time period between thec. relatively long time period between the
initial outlay and the anticipated return.initial outlay and the anticipated return.
- Oster Young- Oster Young

4. Significance of capital budgetingSignificance of capital budgeting
 The success and failure of business mainlyThe success and failure of business mainly
depends on how the available resources aredepends on how the available resources are
being utilised.being utilised.
 Main tool of financial managementMain tool of financial management
 All types of capital budgeting decisions areAll types of capital budgeting decisions are
exposed to risk and uncertainty.exposed to risk and uncertainty.
 They are irreversible in nature.They are irreversible in nature.
 Capital rationing gives sufficient scope for theCapital rationing gives sufficient scope for the
financial manager to evaluate different proposalsfinancial manager to evaluate different proposals
and only viable project must be taken up forand only viable project must be taken up for
investments.investments.
 Capital budgeting offers effective control on costCapital budgeting offers effective control on cost
of capital expenditure projects.of capital expenditure projects.
 It helps the management to avoid over investmentIt helps the management to avoid over investment
and under investments.and under investments.

5. Capital budgeting process involves the followingCapital budgeting process involves the following
1. Project generation1. Project generation: Generating the proposals for: Generating the proposals for
investment is the first step.investment is the first step.
The investment proposal may fall into one of the followingThe investment proposal may fall into one of the following
categories:categories:
 Proposals to add new product to the product line,Proposals to add new product to the product line,
 proposals to expand production capacity in existingproposals to expand production capacity in existing
lineslines
 proposals to reduce the costs of the output of theproposals to reduce the costs of the output of the
existing products without altering the scale of operation.existing products without altering the scale of operation.
 Sales campaining, trade fairs people in the industry, RSales campaining, trade fairs people in the industry, R
and D institutes, conferences and seminars will offerand D institutes, conferences and seminars will offer
wide variety of innovations on capital assets forwide variety of innovations on capital assets for
investment.investment.

6. 2.2. Project EvaluationProject Evaluation: it involves two steps: it involves two steps
 Estimation of benefits and costs: the benefits andEstimation of benefits and costs: the benefits and
costs are measured in terms of cash flows. Thecosts are measured in terms of cash flows. The
estimation of the cash inflows and cash outflowsestimation of the cash inflows and cash outflows
mainly depends on future uncertainities. The riskmainly depends on future uncertainities. The risk
associated with each project must be carefullyassociated with each project must be carefully
analysed and sufficeint provision must be madeanalysed and sufficeint provision must be made
for covering the different types of risks.for covering the different types of risks.
 Selection of an appropriate criteria to judge theSelection of an appropriate criteria to judge the
desirability of the project: It must be consistentdesirability of the project: It must be consistent
with the firm’s objective of maximising its marketwith the firm’s objective of maximising its market
value. The technique of time value of money mayvalue. The technique of time value of money may
come as a handy tool in evaluation suchcome as a handy tool in evaluation such
proposals.proposals.

7. 3.3. Project SelectionProject Selection: No standard administrative: No standard administrative
procedure can be laid down for approving theprocedure can be laid down for approving the
investment proposal. The screening and selectioninvestment proposal. The screening and selection
procedures are different from firm to firm.procedures are different from firm to firm.
4.4. Project EvaluationProject Evaluation: Once the proposal for capital: Once the proposal for capital
expenditure is finalised, it is the duty of the financeexpenditure is finalised, it is the duty of the finance
manager to explore the different alternativesmanager to explore the different alternatives
available for acquiring the funds. He has toavailable for acquiring the funds. He has to
prepare capital budget. Sufficient care must beprepare capital budget. Sufficient care must be
taken to reduce the average cost of funds. He hastaken to reduce the average cost of funds. He has
to prepare periodical reports and must seek priorto prepare periodical reports and must seek prior
permission from the top management. Systematicpermission from the top management. Systematic
procedure should be developed to review theprocedure should be developed to review the
performance of projects during their lifetime andperformance of projects during their lifetime and
after completion.after completion.

8. The follow up, comparison of actual performance withThe follow up, comparison of actual performance with
original estimates not only ensures betteroriginal estimates not only ensures better
forecasting but also helps in sharpening theforecasting but also helps in sharpening the
techniques for improving future forecasts.techniques for improving future forecasts.

9. Factors influencing capital budgetingFactors influencing capital budgeting
 Availability of fundsAvailability of funds
 Structure of capitalStructure of capital
 Taxation policyTaxation policy
 Government policyGovernment policy
 Lending policies of financial institutionsLending policies of financial institutions
 Immediate need of the projectImmediate need of the project
 EarningsEarnings
 Capital returnCapital return
 Economical value of the projectEconomical value of the project
 Working capitalWorking capital
 Accounting practiceAccounting practice
 Trend of earningsTrend of earnings

10. Methods of capital budgetingMethods of capital budgeting
Traditional methodsTraditional methods
 Payback periodPayback period
 Accounting rate of return methodAccounting rate of return method
Discounted cash flow methodsDiscounted cash flow methods
 Net present value methodNet present value method
 Profitability index methodProfitability index method
 Internal rate of returnInternal rate of return

11. Pay back period methodPay back period method
It refers to the period in which the project willIt refers to the period in which the project will
generate the necessary cash to recover the initialgenerate the necessary cash to recover the initial
investment.investment.
It does not take the effect of time value of money.It does not take the effect of time value of money.
It emphasizes more on annual cash inflows,It emphasizes more on annual cash inflows,
economic life of the project and original investment.economic life of the project and original investment.
The selection of the project is based on the earningThe selection of the project is based on the earning
capacity of a project.capacity of a project.
It involves simple calcuation, selection or rejection ofIt involves simple calcuation, selection or rejection of
the project can be made easily, results obtained isthe project can be made easily, results obtained is
more reliable, best method for evaluating high riskmore reliable, best method for evaluating high risk
projects.projects.

12. ConsCons
 It is based on principle of rule of thumb,It is based on principle of rule of thumb,
 Does not recognize importance of time valueDoes not recognize importance of time value
of money,of money,
 Does not consider profitability of economicDoes not consider profitability of economic
life of project,life of project,
 Does not recognize pattern of cash flows,Does not recognize pattern of cash flows,
 Does not reflect all the relevant dimensionsDoes not reflect all the relevant dimensions
of profitability.of profitability.

13. Accounting Rate of Return methodAccounting Rate of Return method
IT considers the earnings of the project of the economic life.IT considers the earnings of the project of the economic life.
This method is based on conventional accounting concepts.This method is based on conventional accounting concepts.
The rate of return is expressed as percentage of theThe rate of return is expressed as percentage of the
earnings of the investment in a particular project. Thisearnings of the investment in a particular project. This
method has been introduced to overcome the disadvantagemethod has been introduced to overcome the disadvantage
of pay back period. The profits under this method isof pay back period. The profits under this method is
calculated as profit after depreciation and tax of the entirecalculated as profit after depreciation and tax of the entire
life of the project.life of the project.
 This method of ARR is not commonly accepted in assessingThis method of ARR is not commonly accepted in assessing
the profitability of capital expenditure. Because the methodthe profitability of capital expenditure. Because the method
does to consider the heavy cash inflow during the projectdoes to consider the heavy cash inflow during the project
period as the earnings with be averaged. The cash flowperiod as the earnings with be averaged. The cash flow
advantage derived by adopting different kinds ofadvantage derived by adopting different kinds of
depreciation is also not considered in this method.depreciation is also not considered in this method.

14. Accept or Reject CriterionAccept or Reject Criterion:: Under the method, all project,Under the method, all project,
having Accounting Rate of return higher than the minimumhaving Accounting Rate of return higher than the minimum
rate establishment by management will be considered andrate establishment by management will be considered and
those having ARR less than the pre-determined rate. Thisthose having ARR less than the pre-determined rate. This
method ranks a Project as number one, if it has highestmethod ranks a Project as number one, if it has highest
ARR, and lowest rank is assigned to the project with theARR, and lowest rank is assigned to the project with the
lowest ARR.lowest ARR.
MeritsMerits
 It is very simple to understand and use.It is very simple to understand and use.
 This method takes into account saving over the entireThis method takes into account saving over the entire
economic life of the project. Therefore, it provides a bettereconomic life of the project. Therefore, it provides a better
means of comparison of project than the pay back period.means of comparison of project than the pay back period.
 This method through the concept of "net earnings" ensures aThis method through the concept of "net earnings" ensures a
compensation of expected profitability of the projects andcompensation of expected profitability of the projects and
 It can readily be calculated by using the accounting data.It can readily be calculated by using the accounting data.

15. DemeritsDemerits
 1. It ignores time value of money.1. It ignores time value of money.
 2. It does not consider the length of life of the projects.2. It does not consider the length of life of the projects.
 3. It is not consistent with the firm's objective of maximizing3. It is not consistent with the firm's objective of maximizing
the market value of shares.the market value of shares.
 4. It ignores the fact that the profits earned can be4. It ignores the fact that the profits earned can be
reinvested. -reinvested. -

16. Discounted cash flow methodDiscounted cash flow method
Time adjusted technique is an improvement over payTime adjusted technique is an improvement over pay
back method and ARR. An investment is essentiallyback method and ARR. An investment is essentially
out flow of funds aiming at fair percentage of returnout flow of funds aiming at fair percentage of return
in future. The presence of time as a factor inin future. The presence of time as a factor in
investment is fundamental for the purpose ofinvestment is fundamental for the purpose of
evaluating investment. Time is a crucial factor,evaluating investment. Time is a crucial factor,
because, the real value of money fluctuates over abecause, the real value of money fluctuates over a
period of time. A rupee received today has moreperiod of time. A rupee received today has more
value than a rupee received tomorrow. In evaluatingvalue than a rupee received tomorrow. In evaluating
investment projects it is important to consider theinvestment projects it is important to consider the
timing of returns on investment. Discounted cashtiming of returns on investment. Discounted cash
flow technique takes into account both the interestflow technique takes into account both the interest
factor and the return after the payback 'period.factor and the return after the payback 'period.

17. Discounted cash flow technique involves the followingDiscounted cash flow technique involves the following
steps:steps:
 Calculation of cash inflow and out flows over theCalculation of cash inflow and out flows over the
entire life of the asset.entire life of the asset.
 Discounting the cash flows by a discount factorDiscounting the cash flows by a discount factor
 Aggregating the discounted cash inflows andAggregating the discounted cash inflows and
comparing the total so obtained with the discountedcomparing the total so obtained with the discounted
out flows.out flows.

18. Net present value methodNet present value method
It recognises the impact of time value of money. It isIt recognises the impact of time value of money. It is
considered as the best method of evaluating theconsidered as the best method of evaluating the
capital investment proposal.capital investment proposal.
It is widely used in practice. The cash inflow to beIt is widely used in practice. The cash inflow to be
received at different period of time will bereceived at different period of time will be
discounted at a particular discount rate. Thediscounted at a particular discount rate. The
present values of the cash inflow are comparedpresent values of the cash inflow are compared
with the original investment. The differencewith the original investment. The difference
between the two will be used for accept or rejectbetween the two will be used for accept or reject
criteria. If the different yields (+) positive value ,criteria. If the different yields (+) positive value ,
the proposal is selected for invesment. If thethe proposal is selected for invesment. If the
difference shows (-) negative values, it will bedifference shows (-) negative values, it will be
rejected.rejected.

19. Pros:Pros:
It recognizes the time value of money.It recognizes the time value of money.
It considers the cash inflow of the entire project.It considers the cash inflow of the entire project.
It estimates the present value of their cash inflows byIt estimates the present value of their cash inflows by
using a discount rate equal to the cost of capital.using a discount rate equal to the cost of capital.
It is consistent with the objective of maximizing theIt is consistent with the objective of maximizing the
welfare of owners.welfare of owners.
Cons:Cons:
It is very difficult to find and understand the conceptIt is very difficult to find and understand the concept
of cost of capitalof cost of capital
It may not give reliable answers when dealing withIt may not give reliable answers when dealing with
alternative projects under the conditions of unequalalternative projects under the conditions of unequal
lives of project.lives of project.

20. Internal Rate of ReturnInternal Rate of Return
It is that rate at which the sum of discountedIt is that rate at which the sum of discounted
cash inflows equals the sum of discountedcash inflows equals the sum of discounted
cash outflows. It is the rate at which the netcash outflows. It is the rate at which the net
present value of the investment is zero.present value of the investment is zero.
It is the rate of discount which reduces the NPVIt is the rate of discount which reduces the NPV
of an investment to zero. It is called internalof an investment to zero. It is called internal
rate because it depends mainly on the outlayrate because it depends mainly on the outlay
and proceeds associated with the project andand proceeds associated with the project and
not on any rate determined outside thenot on any rate determined outside the
investment.investment.

21. Merits of IRR methodMerits of IRR method
 It consider the time value of moneyIt consider the time value of money
 Calculation of casot of capital is not aCalculation of casot of capital is not a
prerequisite for adopting IRRprerequisite for adopting IRR
 IRR attempts to find the maximum rate ofIRR attempts to find the maximum rate of
interest at which funds invested in the projectinterest at which funds invested in the project
could be repaid out of the cash inflowscould be repaid out of the cash inflows
arising from the project.arising from the project.
 It is not in conflict with the concept ofIt is not in conflict with the concept of
maximising the welfare of the equitymaximising the welfare of the equity
shareholders.shareholders.
 It considers cash inflows throughout the lifeIt considers cash inflows throughout the life
of the project.of the project.

22. ConsCons
 Computation of IRR is tedious and difficult toComputation of IRR is tedious and difficult to
understandunderstand
 Both NPV and IRR assume that the cashBoth NPV and IRR assume that the cash
inflows can be reinvested at the discountinginflows can be reinvested at the discounting
rate in the new projects. However,rate in the new projects. However,
reinvestment of funds at the cut off rate isreinvestment of funds at the cut off rate is
more appropriate than at the IRR.more appropriate than at the IRR.
 IT may give results inconsistent with NPVIT may give results inconsistent with NPV
method. This is especially true in case ofmethod. This is especially true in case of
mutually exclusive project.mutually exclusive project.

23. Step 1:Calculation of cash outflowStep 1:Calculation of cash outflow
Cost of project/assetCost of project/asset xxxxxxxx
Transportation/installation chargesTransportation/installation charges xxxxxxxx
Working capitalWorking capital xxxxxxxx
Cash outflowCash outflow xxxxxxxx

24. Step 2: Calculation of cash inflowStep 2: Calculation of cash inflow
SalesSales xxxxxxxx
Less: Cash expensesLess: Cash expenses xxxxxxxx
PBDTPBDT xxxxxxxx
Less: DepreciationLess: Depreciation xxxxxxxx
PBTPBT xxxxxxxx
less: Taxless: Tax xxxxxxxx
PATPAT xxxxxxxx
Add: DepreciationAdd: Depreciation xxxxxxxx
Cash inflow p.aCash inflow p.a xxxxxxxx

25. Note:Note:
 Depreciation = St.Line methodDepreciation = St.Line method
 PBDT – Tax is Cash inflow ( if the taxPBDT – Tax is Cash inflow ( if the tax
amount is given)amount is given)
 PATBD = Cash inflowPATBD = Cash inflow
 Cash inflow- Scrap and working capital mustCash inflow- Scrap and working capital must
be added.be added.

26. Step 3: Apply the different techniquesStep 3: Apply the different techniques
 Pay back period= No. of years + Amt to recover/Pay back period= No. of years + Amt to recover/
total cash of next years.total cash of next years.
 ARR = Average Profits after tax/ Net investment xARR = Average Profits after tax/ Net investment x
100100
 NPV= PV of cash inflows – PV of cash outflowsNPV= PV of cash inflows – PV of cash outflows
 Profitability index = PV of cash inflows/ PV of cashProfitability index = PV of cash inflows/ PV of cash
outflowsoutflows
 IRR :IRR :
Pay back factor: Cash outflow/ Avg cash inflow p.a.Pay back factor: Cash outflow/ Avg cash inflow p.a.
Find IRR rangeFind IRR range
PV of Cash inflows for IRR range and then calculatePV of Cash inflows for IRR range and then calculate
IRRIRR